New conditions are demanding a more sophisticated approach to benchmark blends

Key points

  • New pressures are starting to test firms that create blended benchmarks
  • The EU Benchmarks Regulation has established a new gold standard for the benchmark administration methodologies
  • The challenges of data governance in benchmark blending are being exacerbated by current market conditions

An increasingly broad range of financial sector firms today use blended benchmarks - created by combining multiple market indices – to calculate fees and to provide a point of market comparison for their investment and operational strategies. 

Demand has increased for benchmark blends from asset owners and asset managers for use in multi-asset solutions, asset allocation strategies and liability-matched investments. Before this, capital markets firms routinely used benchmark blends for a range of functions.

However, as benchmark blends are used in greater volume and for a broader range of tasks, new pressures are beginning to test the firms that create blends. These pressures, which centre on regulation, licensing permissions and market volatility, are putting pressure on outdated operating models. They are making firms question exactly where their benchmark blending capability should ‘sit’ and who should conduct the blending activity. 

Good governance
Firms have traditionally taken a relatively unsophisticated approach to making and using benchmark blends. More often than not, blend management was carried out on spreadsheets and e-mail or wedged into existing performance management systems with limited scope for back testing.     

The EU Benchmarks Regulation (BMR) has established a new gold standard for the benchmark administration methodologies. And although the obligatory elements of the regulation do not directly apply to benchmark blending, the spirit of the regulation does. From this perspective, a benchmark should be unambiguous, investible, measurable, appropriate, reflective of investment opinions and specified in advance. 

By applying these standards to the area of benchmark blends, firms will provide the levels of quality and transparency that regulators are hoping for and investors will increasingly demand.  

Good governance is also a factor in cost management. Given that benchmark blends use market indices provided by third-party index providers, firms need to be aware of the licensing and cost implications of their blending activity. Index providers may well be getting ready to focus in on blends as a source of revenue, and firms will need to be aware of exactly what their licence does and does not allow them to do with regard to blending. 

Market volatility
The challenges of data governance in benchmark blending is being exacerbated by current market conditions. The COVID-19 crisis has led to some of the most turbulent market conditions on record and it is likely that there will be future challenges ahead. 

This is the first time that firms have had to work around shifting rebalancing dates and prolonged uncertainty – a real challenge when it comes to blends, given that firms are dealing with multiple index providers and policies. Missing a rebalancing schedule risks exposing firms and their benchmarks to out-of-date market assumptions. The financial consequences of this can be severe: one large US investment manager had to pay $105m (€93m) to investors after an error made during its quarterly rebalancing which caused a fund to lag its index by 170 points.

A modern blending function
To overcome the governance challenges arising from regulation, market volatility and licensing issues, firms need to ensure they have a robust blending capability. This should include:

● Real-time provider-monitoring capabilities to be able to keep up with changes to constituent indexes both within and without scheduled rebalancing windows
● Skilled data managers to quality control index data from a large number of ever-changing datasets and to alter blend weights and compositions of indices to match the target outcomes of given asset allocations
● Fit-for-purpose systems to automate data sourcing, validation and distribution where possible to accelerate data management processes and reduce costs
● Robust governance for control and transparency across operational processes

Such a capability is a world away from the spreadsheet-based approaches of the past, requiring data management expertise and systems. But as a non-core activity, firms may be unwilling to dedicate resources that could otherwise be focused on investment and distribution. The requisites of a modern blending capability may therefore lead many firms to look for outside help.

There is another, more compelling reason to seek third-party support. There is a preference from regulators around the world for a separation of duties between the team blending the benchmark and the investment team using the benchmark. The concern seems to be that if there is not enough distance between the team blending the benchmark and the investment team tracking the benchmark, the two could inappropriately share information. This concern is magnified where a fund is managed for external clients. 

In the US, the Securities and Exchange Commission, the main regulator, has intimated as much in its regulations relating to 40 Act Funds, where it states: “an ‘appropriate broad-based securities market index’ is one that is administered by an organisation that is not an affiliated person of the Fund, its investment adviser, or principal underwriter, unless the index is widely recognised and used”. In Europe, meanwhile, the Council of the EU has stated that “benchmarks are susceptible to manipulation where conflicts of interest and discretion exist in the benchmark process and these [benchmarks] are not subject to adequate governance and controls” – concerns that could equally apply to benchmark blends. 

When combined with the cost and complexity of managing benchmarks in-house, the need for firms to separate the duties of benchmark blending and multi-asset investing make the case for a managed services approach. This approach gives firms access to the skilled data professionals and systems they need and are provided at a low total cost of ownership compared with in-house models as they can leverage economies of scale. Managed benchmark services also insulate firms from change and allow them to focus on what they do best. 

Andrew Barnett is global head of product strategy at RIMES

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